The Art of the 'No Deal'

The highly publicized merger between two European manufacturing powerhouses seems particularly unfair and could easily be repackaged to make it more palatable to income investors, writes Stephen Bland of Motley Fool UK.

I've decided to write today about BAE Systems (London: BA). I wasn't going to, even though this share has been a value selection of mine in the past and continues to display some value, as well as being an attractive High Yield Portfolio holding, which—in fact—I hold in my own HYP.

But what prompted me to bash the keyboard was the proposed merger with a Dutch airplane business known as EADS. Bear in mind that I'm coming at this from a value/yield perspective and am prepared to disregard the emotional, political, or military considerations, xenophobia, and so on, which seem to have preoccupied a lot of the comments I've read so far.

The merger is a long way from coming to fruition and has a lot of hurdles to surmount, but clearly both parties want it to succeed. They have made it official; it's not just market gossip.

Unfortunately, the small investor has no real say in this, because it is the institutions that control the share capital of BAE Systems, and all big caps and their interests are frequently diametrically opposed to those of the small guy, especially the income investor. I expect that to be the case here.

Deal or No Deal?
I don't like this deal. My main reason is that, as an income holder of BAE Systems, it appears to me that the dividend is very likely to be hit because EADS has a much lower yield. So instead of their shareholders being dragged up to our level, we're being dragged down to theirs.

The merger statement tells us that the 2013 dividend will be unchanged on the 2012 level. That is already poor news, because a modest rise was forecast for BAE Systems for 2013 over 2012. Forecasts are never certain, but that was what the analysts' consensus predicted. That will now not happen if the merger goes ahead.

That's the first blow to send you reeling, but the knockout punch for income investors is what happens in 2014 and later. They give no indication other than that payouts will depend upon various factors.

I don't expect them to promise anything, but reading between the lines suggests strongly to me that a cut is very likely—a "rebalancing" in the usual corporate euphemism—one good reason alone being the existing lower payouts of EADS.

The shareholders of the latter company will become the larger proportion in the merged group, 60% to BAE Systems's 40%. So as an income investor, on these expectations alone I am against the merger.

Next: There are other reasons

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There are other reasons, too. The dual-listing structure proposed may well lead to some complex share arrangements, perhaps something like Royal Dutch Shell (London: RDS.B) with its A and B shares and resulting tax complication between Holland and the UK. I've known Shell investors here who have inadvertently bought the A shares when UK investors should be buying the B shares.

A further reason is that I understand that EADS is involved principally in civilian aircraft manufacture. Well, I bought BAE Systems because it is in the offence business—a nice, desirable, dependable thing to have, offering attractive diversification for an HYP. I don't want no stinkin' civvie airplane builder—that's far too risky for the widows-and-orphans HYP investor like me.

It has been said that everything has a price, and so does BAE Systems. If this was a cash bid with a sufficiently large premium over the pre-announcement price, I'd be more accepting of its succumbing, because that large premium and consequently lowered exit yield would enable reinvestment in new HY shares to deliver as good or better income.

But as a paper merger, it offers little that I can see to the value or HYP investor with the modest 10% or so rise yesterday on the announcement having largely been retracted as I write. So there is no sure compensation for what will in my view be an income loss in future.

For the existing BAE Systems, the 2012 consensus forecast dividend is 19.6p and for 2013 it is 20.2p. The 2011 actual was 18.8p. Those are not big increases, only about 3% to 4% year on year, but at least they are increases.

With the shares currently at 340p, the historical yield is 5.53% and the forecasts are 5.76% followed by 5.94%. Those are good yields, well into HYP territory and also value land.

Admittedly, BAE Systems doesn't have a lot else going for it as a value play. It has massive negative tangible assets, it has net debt, and the forecast 2012 price-to-earnings ratio of about 9 is merely reasonable, lacking the profundity of a heavyweight value share. But with big-cap plays, I'm often willing to forgive a lot as a tradeoff for their sheer size, though it is the HYP aspect that most bothers me here.

As a small shareholder, in a vote my influence—and even that of all small private shareholders acting in concert—will be less effectual than a fart in a hurricane. And worse, a lot of small shareholders usually don't bother to vote in these things anyway.

But I hope the merger fails, or if not, that the terms are improved from an income viewpoint. However, I don't think that, if it does go through, any improvement will be made to the income aspect.